There is an argument that cyclical stocks have moved too far too fast. “There are many stocks that have rallied,” says Alphen Asset Management's Adrian Clayton “This is because of an improvement in sentiment. But share prices have run ahead of the profits in companies.” The risk for investors, he says, is that profits will not achieve the high levels expected.
So, if solid and dependable is what you are after, one stock that stands out is LSE and JSE-listed British American Tobacco Some may find this strange.
“BAT has underperformed the Alsi by more than one third since its listing late last year,” says Allan Gray portfolio manager Simon Raubenheimer “And it is down by 10% relative to the Alsi since July.”
Yet both he and Clayton believe the share holds long-term value.
“We are in a strange situation where a quality business that is defensive has de rated, while others that are not in the same league have re-rated. Poorer-quality businesses have led the market higher around the world,” says Clayton.
BAT, the world's second-biggest publicly listed tobacco company, with a market value of £33,5bn or R394bn, has weathered the recession so far, growing profit from operations by 22% in the six months to July. It has done this despite the economic crisis having shrunk sales volumes by an average 2%/year.
And despite the difficult economic and trading conditions the company faces in many territories, CEO Paul Adams believes it is on track to deliver a full year of strong earnings growth.
Declining volumes are a reality that the company has taken stock of — recession or not: “We believe organic volumes will drop by 1%-2%, principally as a result of declining market sizes around the world,” says Adams. “We think smokers will consume fewer cigarettes each year and that smaller percentages of populations will smoke.
“However, the number of adults in the world over the age of 20 is forecast to grow around 11% over the next 10 years. As a result we expect annual sales to be broadly unchanged in a decade's time.”
Volumes aside, the immediate challenge to the business will be the growing “downtrading” to cheaper brands, as well as managing illicit trade, says Raubenheimer. Roughly 11,6% of the global cigarette market is illegal, equal to around 657bn cigarettes/year.
What is attractive about BAT, though, is that it has a solid plan to grow earnings, despite the pressure on volumes caused by increasing health concerns, smoking bans, higher taxes and advertising restrictions.
“The main levers BAT can utilise to drive earnings are pricing, cost control and innovation,” Raubenheimer says.
BAT makes Kent, Dunhill, Lucky Strike and Vogue, and the company is pushing hard to win smokers over to these brands. “To gauge the success of this, compare the sales of these brands as a percentage of volumes in 2000 and 2008,” says Clayton. “In 2000 these ‘drive' brands accounted for 13% of volumes; in 2008 it was 26%. In total, top brands account for 49% of BAT's volumes as against 72% for Philip Morris, indicating that pricing upside is still possible for BAT.”
On the innovation front, the company is developing new, higher-priced products. The Kent nanotek offers the same puff at half the size of a normal cigarette.
Another positive for any would-be investor is that the company remains highly cash generative. “Over time, we would expect most of this cash to be returned to shareholders by way of dividends or share buybacks,” says Raubenheimer.
He expects earnings growth of 20% for 2009. A dividend yield of almost 5% is forecast.
Yes, growth will slow. “But come hell or high water, a billion people are not going to suddenly stop smoking,” says Clayton.
With BAT, investors are not chasing a share price. “It is about buying into a company, understanding the drivers, the performance and strategy,” says Clayton. “This is a company making meaningful profits in a market where predictability is high.”
Source: Financial Mail
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